Vertical Integration in DistributionMktg 427 – Chapter 8

Learning Objectives• Understand vertical integration as a continuum from make to

buy rather than as merely a binary choice.• Why do companies integrate with great expectations, then

divest a few years later?• Frame vertical integration decision in terms of ROI• Explain six reasons why outsourcing should be a starting point.• Define and explain the six categories of company specific

capabilities.• Understand the impact of a volatile environment on returns

from forward integration• Understand performance ambiguity in vertical integration

Introduction• This chapter concerns the most fundamental question to ask

when structuring a delivery system:

• Should only one organization do the work, thereby vertically integrating into the distribution stage?

• Or should distribution flows be outsourced (upstream looking down)

• Or should production be outsourced (downstream looking up)

Introduction• To integrate is to become one, or singular.

• When the manufacturer integrates a distribution function (making sales, fulfilling orders, offering credit, etc.), the manufacturer’s employees do the work and the manufacturer has integrated forward or downstream, from the point of production.

• Vertical integration also occurs in a downstream direction: A distributor or retailer can product its own branded source of product, thereby integrating backward.

Make or Buy• The vertical integration decision is not a channel structure

decision per se, but rather a decision that should be made channel flow by channel flow.

• In marketing channels, make-or-buy decisions (vertically integrate or outsource) are critical strategic choices.

• The firm’s decision to own some or all of its marketing channel has an enduring influence on its ability not only to distribute but also to produce.

Chapter Organization• The issues involved in vertical integration of distribution are

many and complex.

• Managers need a structured way to work through the issues, frame a coherent, comprehensive rationale and reach a decision (make or buy, flow by flow) that can be communicated convincingly.

• More often than not the manufacturer should NOT vertically integrate a downstream flow because doing so is typically inefficient. Only integrate IF it has the resources to own and would increase its ROI in the long run. Same with downstream.

The Costs and Benefits of V.I.

Classical MarketContracting

Quasi-verticalIntegration

VerticalIntegrationFunction

1) Selling (only) Manufacturers’ “Captive” or Exclusive Producer SalesRepresentatives Sales Agency * Force (direct

sales force)

2) Wholesale Independent Distribution Distribution Distribution Wholesaler Joint Venture Arm of Producer

3) Retail Independent Franchise CompanyDistribution (3rd party) Store Store

* Operationally, a sales agency deriving more than 50% of its revenues from one principal

EXAMPLES OF INSTITUTIONS PERFORMING SOME CHANNEL FLOWS

Costs and Benefits of the Choice to ‘Make’• What changes when you choose the ‘make’ option over the

‘buy’ option?

• If you are the manufacturer, your organization assumes all the accounting costs of distribution (channel flow costs and personnel costs)

• All too often, the result is that vertical integration forward not only fails to improve market share but actually reduces ROI.

Costs and Benefits of the Choice to ‘Make’• Many manufacturers find the heaviest of these costs to be the

opportunity cost of the personnel – they often do not have anyone to be diverted from manufacturing to distribution.• Insufficient resources for forward integration

• These costs can only be justified by substantial benefits:• CONTROL over the operation (only beneficial if firms’ managers

can use it skillfully to improve economic result)• When manufacturing loses appeal (IBM and GE) – much of the

profit for their capital equipment is not from sales but from maintenance.

Deciding when to vertically integrate forward• Return on Investment: The Usual Criterion

• For vertical integration to be efficient, it must somehow increase revenues more than it increases variable costs in order to improve net effectiveness.

• However, two circumstances prevent vertical integration from moving forward even though it would add to ROI.1. Firm does not have and cannot obtain resources to integrate

forward2. It could exhaust the firm’s capacity

Outsourcing as a starting point• The fundamental rationale is that under normal circumstances

in a developed economy, markets for distribution services are efficient.

• This does not mean that markets for distribution services function perfectly or even function well. It simply means that given current environmental conditions, technology and know-how, it is difficult for a given manufacturer to get better operating results compared to third-party services.

Six Reasons to Outsource Distribution1. Motivation2. Specialization3. Survival of the economically fittest4. Economies of scale5. Heavier market coverage6. Independence from any single

manufacturer

Vertical Integration Forward when Competition is low• When Competition is Low

• The first and most frequent noncompetitive scenario is that of small-numbers bargaining arising from company specific capabilities.

“the accumulation of company-specific assets creates an economic rationale to vertically integrate” … This is because the holder of capabilities (reseller) are valuable and irreplaceable.

• WHY VERTICALLY INTEGRATE??• Company specific capabilities (barriers to entry)• Lack of leverage (threat)• Opportunism avoidance

Six types of Company-specific Capabilities in Distribution1. Idiosyncratic Knowledge - cannot be readily deployed to

another principal.2. Relationships – connections between distributor personnel and

manufacturer personnel or customers.3. Brand equity that derives from the channel partner’s activities

– the more valuable the brand, the more likely the need for vertical integration

4. Customized physical facilities - proprietary hardware and other physical adaptations that binds an upstream or downstream channel partner (e.g. SHIPPING)

5. Dedicated capacity6. Site specificity - e.g. distribution outlet near a remote

manufacturer or manufacturer needing a warehouse in a market void of distributors

VI for Environmental Uncertainty• When an environment is difficult to forecast due to dynamics

or complexities. Volatile. A OR B?

A. Manufacturer should take control to cope with volatility(3rd party switching?)

B. Do not commit to any distribution system until uncertainty is reduced(litotes difficulty of organization change to match market volatility).

Low Specificity High Specificity

Highly Volatile Market

Outsource Distributionto Retain FlexibilityUntil Uncertainty Is

Reduced

Highly PromisingMarket

Less PromisingMarket

Vertically Integrateto Gain Control OverEmployees And Avoid

Small-Numbers BargainingIn Changing Circumstances

Do Not Enter

FG 7.2: HOW ENVIRONMENTAL UNCERTAINTY IMPACTS VERTICAL INTEGRATION

VI to reduce Performance Ambiguity• Performance Ambiguity:

• No baselines to measure against (radically new, innovative, inability to measure)

• Poor quality measures (untimely, inaccurate)• A failure of information

• In a normal market, the manufacturer offers to pay an organization for distribution services to be provided. If the service is not performed satisfactorily, the principal either negotiates for better outcomes with the agent or finds another agent.

• Bid Monitor Reconsider Re-bid

• Herein lies a fundamental problem with market contracting, When there is performance ambiguity, the manufacturer cannot discern what level of performance it is getting.

Consider overturning outsource presumption:

Vertical Integration,increasingly attractive

Presume outsourcing is more attractive than vertical integration

Examine how function will develop

Outsourcing remains attractive

Will substantial company-specific

investments accrue?

Volatile, uncertain environment(accelerates effect of company-specific

investments)

GO!

Outsourcingpreferable

Is potential business major or substantial?

Will performance

ambiguity be high?

Start here

(Take both roads and see where they go)

NO

YES

NO NO

YESYES

FIGURE 7.4: ROAD MAP TO THE VERTICAL INTEGRATION DECISION